Forecasting the Presidency

You may have noticed there is a presidential election coming
up.The Republican Party met this past
week in Tampa, Florida and officially nominated Mitt Romney as their
candidate.Democrats are meeting this
week in Charlotte, North Carolina to renominate President Barack Obama.Of course all that really matters is the
counting of electoral college votes, and those will be decided on November 6th.

In the meantime, however, it is at least entertaining to try
and predict which candidate will win.There is no shortage of opinion, of course.In the past week I have read that an Obama
win is a sure thing, that Romney is sure to win, and that the election is too
close to call.

Social scientists have been studying presidential elections
for decades and have become quite adept at using statistical analysis to
predict their outcome.One of the
earliest pieces of evidence is a scholarly paper by economist Ray Fair of Yale
University that was published in the Review of Economics and Statistics in
1978.Fair showed that the most
important predictor of the outcome was the growth rate of the economy in the
year preceding the election.High growth
rates substantially boosted the probability of the candidate from the
incumbent's party winning the election.The evidence was so strong, in fact, that Fair concluded the
contribution of other observable factors was negligible by comparison.

More recent studies - and there is a now a small industry
producing them - tend to largely confirm Fair's results.Kenneth Bickers and Michael Berry of the
University of Colorado - Denver made the news in August when they released a
study showing that economic indicator collected on a state-by-state basis
predicted a Republican landslide.Based
on data through June their model predicted a 320 - 218 margin for Romney in the
electoral college with 52.9 percent of the popular vote going in his favor.

A recent technological innovation in presidential elections
is the use of prediction markets.Political markets have been around since at least the early 1990s when a
small-scale political derivatives market now called the Iowa Electronics Market
(IEM) was set up at the Tippie College of Business at the University of
Iowa.The most widely cited source these
days is the online trading site InTrade.

Prediction markets like these are used to forecast the
results of all sorts of uncertain events, from the Oscar for Best Picture, to
the odds that extraterrestrial life will be discovered before the end of
2015.The accuracy of these predictions
is built on what finance researchers call the efficient markets
hypothesis.Boiled down to its basics
the hypothesis says that all available information about an event is reflected
in the price of an asset linked to that event.The intuition being that when large sums of money are at stake investors
in these markets will be quite thorough in sifting and analyzing all relevant
information.

It is often argued that the predictions from these markets
are more accurate than even the best conducted polls.Respondents to polls, after all, have no
financial incentive to accurately report their true preferences.Indeed, they may fudge their responses
substantially in order to give an answer they think the interviewer wants to hear.

Investors in political prediction markets have access to all
publicly available information, so they can certainly incorporate information
from polls.But they may also have
access to useful private information.For example, suppose a close friend of a Republican candidate knew an
embarrassing secret was about to be uncovered.That friend could make a great deal of money if he were to buy shares in
an asset on InTrade or IEM that pays out should the Democrat win.On InTrade, a typical asset pays $10 should a
candidate win the election.While the
secret remains hidden, suppose the price of the Democratic candidate asset is
$2, indicating a 20% chance winning.If
the close friend buys these now and holds them until the secret is revealed he
can make a killing when the price rises to say $6.And the more assets he buys the bigger the
payoff.However, the act of buying large
numbers of these assets will in itself push the price up.In this way the market price comes to reflect
all the relevant information regardless of whether that information is publicly
known or not.

So what do the prediction markets say about the upcoming
election?Despite Bickers and Berry's
prediction of a big Republican win, Romney shares are selling on Intrade now
for 43 cents on the dollar, indicating a roughly 43% chance he will win the
election this November.Prices on the
IEM are almost identical.

Romney may yet win the election, but people who have real
money at stake are giving Obama better odds of winning, at least for now.Of course, if you feel they're wrong, you are
certainly free to buy as many of those undervalued Romney shares as you want.